Hedge Fund Activism, Corporate Governance, and Firm Performance

Hedge Fund Activism, Corporate Governance, and Firm Performance ALON BRAV, WEI JIANG, FRANK PARTNOY, and RANDALL THOMAS* ABSTRACT Using a large hand-collected data set from 2001 to 2006, we find that activist hedge funds in the U.S. propose strategic, operational, and financial remedies and attain success or partial success in two-thirds of the cases. Hedge funds seldom seek control and in most cases are non- confrontational. The abnormal return around the announcement of activism is approximately 7%, with no reversal during the subsequent year. Target firms experience increases in payout, operating performance, and higher CEO turnover after activism. Our analysis provides important new evidence on the mechanisms and effects of informed shareholder monitoring. JEL Classification: G14, G23, G3. Keywords: Hedge Fund, Activism, Corporate Governance. * Brav is with Duke University, Jiang is with Columbia University, Partnoy is with University of San Diego, and Thomas is with Vanderbilt University. The authors have benefited from discussions with Patrick Bolton, Bill Bratton, Martijn Cremers, Gregory Dyra, Alex Edmans, Allen Ferrell, Gur Huberman, Joe Mason, Edward Rock, Mark Roe, Roberta Romano, Tano Santos, William Spitz, Gregory van Inwegen, and comments from seminar and conference participants at the American Law and Economics Association, Arizona State University, Association of American Law Schools, BNP Paribas Hedge Fund Centre Symposium, Chicago Quantitative Alliance, Columbia University, The Conference Board, Drexel University, Duke University, FDIC, University of Florida, Goldman Sachs Asset Management, Hong Kong University of Science and Technology, Interdisciplinary Center (Herzlyia, Israel), Inquire (UK), University of Kansas, London Business School, Nanyang Technological University, National University of Singapore, Singapore Management University, Society of Quantitative Analysts, University of Amsterdam, U.S. Securities and Exchange Commission, University of Texas at Austin, University of Virginia, University of Washington, Washington University in St. Louis, Wharton, the European Financial Management Association annual meeting in Vienna, and the Vanderbilt Investor Activism Conference. We owe special thanks to a large number of research assistants for their help in data collection and, in particular, to Jennifer Blessing, Amod Gautam, Greg Klochkoff, and Samantha Prouty. We also thank George Murillo for excellent research assistance. Brav and Jiang acknowledge the financial support from the FDIC, the Q-Group, and the Yale/Oxford Shareholders and Corporate Governance Research Agenda. Jiang also thanks support from Ivy Asset Management Corp. through their partnership with Columbia Business School. Although hedge fund activism is widely discussed and fundamentally important, it remains poorly understood. Much of the commentary on hedge fund activism is based on supposition or anecdotal evidence. Critics and regulators question whether hedge fund activism benefits shareholders, while numerous commentators claim that hedge fund activists destroy value by distracting managers from long- term projects. However, there is a dearth of large-sample evidence about hedge fund activism, and existing samples are plagued by various biases. As a result, even the most basic questions about hedge fund activism remain unanswered: Which firms do activists target and how do those targets respond? How does the market react to the announcement of activism? Do activists succeed in implementing their objectives? Are activists short-term in focus? How does activism impact firm performance? In this paper, we answer these questions by constructing the most extensive and thoroughly documented set of observations of hedge fund activism to date, extending from the beginning of 2001 through the end of 2006. We find that hedge funds increasingly engage in a new form of shareholder activism and monitoring that differs fundamentally from previous activist efforts by other institutional investors. Earlier studies show that when institutional investors, particularly mutual funds and pension funds, follow an activist agenda, they do not achieve significant benefits for shareholders (Karpoff (2001), Romano (2001), Black (1998), and Gillan and Starks (2007)). Our results suggest that the opposite is true of hedge funds. Unlike mutual funds and pension funds, hedge funds are able to influence corporate boards and managements due to key differences arising from their different organizational form and the incentives that they face. Hedge funds employ highly incentivized managers who manage large unregulated pools of capital. Because they are not subject to regulation that governs mutual funds and pension funds, they can hold highly concentrated positions in small numbers of companies, and use leverage and derivatives to extend their reach. Hedge fund managers also suffer few conflicts of interest because they are not beholden to the management of the firms whose shares they hold. In sum, hedge funds are better positioned to act as informed monitors than other institutional investors. Hedge fund activists tend to target companies that are typically “value” firms, with low market value relative to book value, although they are profitable with sound operating cash flows and return on assets. Payout at these companies before intervention is lower than that of matched firms. Target companies also have more takeover defenses and pay their CEOs considerably more than comparable companies. Relatively few targeted companies are large-cap firms, which is not surprising given the relatively high cost of amassing a meaningful stake in such a target. Targets exhibit significantly higher institutional ownership and trading liquidity. These characteristics make it easier for activists to acquire a significant stake quickly. 2 Our first piece of evidence regarding the impact of hedge fund activism is based on the market’s reaction to intervention announcements. We find that the market reacts favorably to activism, consistent with the view that it creates value. The filing of a Schedule 13D revealing an activist fund’s investment in a target firm results in large positive average abnormal returns, in the range of 7% to 8%, during the (- 20,+20) announcement window. The increase in both price and abnormal trading volume of target shares begins one to 10 days prior to the 13D’s filing. We find that the positive returns at announcement are not reversed over time, as there is no evidence of a negative abnormal drift during the 1-year period subsequent to the announcement. We also document that the positive abnormal returns are only marginally lower for hedge funds that disclosed substantial ownership positions (through quarterly Form 13F filings) before they file a Schedule 13D, which is consistent with the view that the abnormal returns are due to new information about activism, not merely that about stock picking. Moreover, target prices decline upon the exit of a hedge fund only after it has been unsuccessful, which indicates that the information reflected in the positive announcement returns conveys the market’s expectation for the success of activism. We next examine the cross-section of these abnormal returns. Activism that targets the sale of the company or changes in business strategy, such as refocusing and spinning-off noncore assets, is associated with the largest positive abnormal partial effects, at 8.54% and 5.95%, respectively (the latter figure is lower than the overall sample average because most events target multiple issues). This evidence suggests that hedge funds are able to create value when they see large allocative inefficiencies. In contrast, we find that the market response to capital structure-related activism—including debt restructuring, recapitalization, dividends, and share repurchases – is positive yet insignificant. We find a similar lack of statistically meaningful reaction for governance-related activism—including attempts to rescind takeover defenses, to oust CEOs, to enhance board independence, and to curtail CEO compensation. Hedge funds with a track record of successful activism generate higher returns, as do hedge funds that initiate activism with hostile tactics. The positive market reaction is also consistent with expost evidence of overall improved performance at target firms. On average, from the year before to the year after an announcement, total payout increases by 0.3 to 0.5 percentage points (as a percentage of the market value of equity, relative to an all-sample mean of 2.2 percentage points), and book value leverage increases by 1.3 to 1.4 percentage points (relative to an all-sample mean of 33.5 percentage points). Both changes are consistent with a reduction of agency problems associated with free cash flow and subject managers to increased market discipline. We also find improvement in return on assets and operating profit margins, but this takes longer to manifest. The post-event year sees little change compared to the year prior to intervention. However, EBITDA/Assets (EBITDA/Sales) at target firms increases by 0.9 to 1.5 (4.7 to 5.8) percentage 3 points two years after intervention. Analyst expectations also suggest improved prospects at target firms after hedge fund intervention. During the months before Schedule 13D filings, analysts downgrade (future) targets more than they upgrade them, whereas after an intervention is announced analysts maintain neutral ratings. Given that successful activism often leads to

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